These 4 Measures Indicate That Shanghai Waigaoqiao Free Trade Zone Group (SHSE:600648) Is Using Debt In A Risky Way

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shanghai Waigaoqiao Free Trade Zone Group Co., Ltd. (SHSE:600648) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shanghai Waigaoqiao Free Trade Zone Group

What Is Shanghai Waigaoqiao Free Trade Zone Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai Waigaoqiao Free Trade Zone Group had debt of CN¥22.1b, up from CN¥17.5b in one year. However, it does have CN¥5.09b in cash offsetting this, leading to net debt of about CN¥17.0b.

A Look At Shanghai Waigaoqiao Free Trade Zone Group's Liabilities

According to the last reported balance sheet, Shanghai Waigaoqiao Free Trade Zone Group had liabilities of CN¥22.3b due within 12 months, and liabilities of CN¥10.2b due beyond 12 months. On the other hand, it had cash of CN¥5.09b and CN¥1.45b worth of receivables due within a year. So it has liabilities totalling CN¥26.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥11.9b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shanghai Waigaoqiao Free Trade Zone Group would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a net debt to EBITDA ratio of 8.2, it's fair to say Shanghai Waigaoqiao Free Trade Zone Group does have a significant amount of debt. However, its interest coverage of 3.0 is reasonably strong, which is a good sign. Even worse, Shanghai Waigaoqiao Free Trade Zone Group saw its EBIT tank 26% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanghai Waigaoqiao Free Trade Zone Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shanghai Waigaoqiao Free Trade Zone Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Shanghai Waigaoqiao Free Trade Zone Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Shanghai Waigaoqiao Free Trade Zone Group is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Shanghai Waigaoqiao Free Trade Zone Group you should be aware of, and 1 of them is a bit unpleasant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.